Question

Which of the following statements best describes capital rationing?

a. capital rationing occurs when the firm invests to the point where the marginal internal rate of return equals the marginal cost of capital.
b. capital rationing occurs when a firm invests less than the optimal amount (the point where the marginal rate of return equals the marginal cost of capital) because the firm might be small and it doesn't have the ability to take on as many projects as the optimal amount might indicate.
c. capital rationing indicates that the firm is investing less than the optimal amount. this should never happen and rarely occurs in the real world.
d. capital rationing is the term used to describe when a multidivisional company distributes capital among its various divisions.
e. none of the statement above correctly describes capital rationing.

Answer 1

Capital rationing occurs when a firm invests less than the optimal level due to financial constraints or limited access to capital, despite having profitable investment opportunities.

Step-by-step explanation:

The correct answer is (b): Capital rationing occurs when a firm invests less than the optimal amount (the point where the marginal rate of return equals the marginal cost of capital) because the firm might be small and it doesn't have the ability to take on as many projects as the optimal amount might indicate. This is often due to limitations on available financial capital, which can result from various market conditions and firm-specific factors.

In the context of capital budgeting, a firm aims to select projects that maximize its value subject to the constraint of limited capital. If it had access to unlimited capital at the marginal cost of capital, the firm would continue to invest in all projects that offer a return higher than this cost. However, firms usually face capital constraints and have to ration their capital, thus investing in projects with the highest returns until the available capital is exhausted. Capital rationing is sometimes a result of imperfect information in the market, which affects how businesses and outside investors perceive the future profitability of investments.